What Investment Criterion Methods Do Firms Favor?

When it comes to investment criteria, firms tend to use two main methods: the internal rate of return (IRR) and the net present value (NPV). These methods are part of the capital budgeting process, which involves choosing projects that add value to a company. Capital budgeting is a long-term financial plan for larger financial outlays, and it helps businesses determine which projects or investments to pursue based on their potential profitability, risk factors, and alignment with the company's current financial capacity and long-term objectives. The IRR is the expected return on a project, while the NPV shows how profitable a project will be compared to alternatives.

Internal Rate of Return

Two of the most widely used investment criterion methods by firms are Internal Rate of Return (IRR) and Net Present Value (NPV).

Calculating the IRR can be done in three ways:

• Using the IRR or XIRR function in Excel or other spreadsheet programs
• Using a financial calculator
• Using an iterative process where the analyst tries different discount rates until the NPV equals zero

IRR is often used to choose between investment options by completing a form of discounted cash flow (DCF) analysis. It is the discount rate that would bring an investment's net present value (NPV) to zero. An NPV of zero would mean the investment breaks even: the present value of all future cash flows equals the investment's generated revenue, associated costs, and initial investment amount.

IRR gives the yield rate, or the expected return on investment, shown as a percentage of the investment. For example, a $10,000 investment with a 20% IRR would generate $2,000 in profit. However, IRR is a type of compound annual growth rate, meaning the annual yield from the investment is reinvested (or compounded).

IRR is also commonly used in corporate finance settings, such as venture capital and private equity firms, when assessing potential companies to invest in. In the fixed income and equities area of investment banking, analysts may rely on IRR to understand a bond's yield rate.

When evaluating an investment option, it is important to consider other factors in addition to IRR, such as the company's risk tolerance, economic conditions, and the total duration of the potential investment.

Net Present Value

NPV is the result of calculations that find the current value of a future stream of payments using the proper discount rate. The discount rate may reflect the cost of capital or the returns available on alternative investments of comparable risk. The discount rate is central to the NPV formula as it accounts for the fact that a dollar today is worth more than a dollar in the future due to inflation and interest rates.

NPV is used to calculate the current value of a future stream of payments from a company, project, or investment. It is an all-encompassing metric that takes into account all revenues, expenses, and capital costs associated with an investment. It also considers the timing of each cash flow, which can significantly impact the present value of an investment. For example, cash inflows are preferable to cash outflows.

NPV analysis is used to determine how much an investment, project, or series of cash flows is worth. It is a form of intrinsic valuation used extensively in finance and accounting to determine the value of a business, investment security, capital project, new venture, cost reduction program, or anything involving cash flow.

The NPV formula yields a dollar result that is relatively easy to interpret. A positive NPV indicates that the projected earnings from an investment exceed the anticipated costs, representing a profitable venture. Conversely, a negative NPV suggests that the expected costs outweigh the earnings, signalling potential financial losses. Therefore, a higher NPV is generally considered more favourable as it indicates greater profitability and value creation.

Discounted Cash Flow Analysis

Discounted Cash Flow (DCF) is a widely used valuation method that estimates the value of an investment using its expected future cash flows. It is used by professional investors and analysts at investment banks to determine how much to pay for a business, whether for shares of stock or for the entire company. It is also used by financial analysts and project managers in major companies to determine whether a given project will be a good investment, such as for a new product launch or a new manufacturing facility.

DCF analysis helps investors who are considering whether to acquire a company or buy securities. It can also assist business owners and managers in making capital budgeting or operating expenditure decisions. It is useful in any situation where a person is paying money in the present with the expectation of receiving more money in the future. For example, if you have $1 in a savings account with a 5% annual interest rate, that dollar will be worth $1.05 in a year. Conversely, if a $1 payment is delayed for a year, its present value is 95 cents.

The DCF formula is:

DCF = CF1 / (1 + r) ^ 1 + CF2 / (1 + r) ^ 2 + ... + CFn / (1 + r) ^ n

Where:

• DCF = Discounted Cash Flow
• CF1 = Cash flow for year one
• CF2 = Cash flow for year two
• CFn = Cash flow for additional years
• R = Discount rate

The discount rate in DCF analysis is the interest rate used when calculating the net present value (NPV) of the investment. It represents the time value of money from the present to the future. Companies typically use the weighted average cost of capital (WACC) for the discount rate because it accounts for the rate of return expected by shareholders.

To conduct a DCF analysis, an investor must estimate future cash flows and the end value of the investment, equipment, or other assets. The investor must also determine an appropriate discount rate for the DCF model, which will vary depending on the project or investment under consideration. Factors such as the company or investor's risk profile and the conditions of the capital markets can influence the discount rate chosen.

DCF analysis can be useful in providing investors and companies with a reasonable projection of whether a proposed investment is worthwhile. It can be applied to a variety of investments and capital projects where future cash flows can be reasonably estimated. Its projections can be adjusted to provide different results for various scenarios, helping users account for different possibilities.

However, the major limitation of DCF analysis is that it relies on estimates of future cash flows, which may be inaccurate. Future cash flows depend on various factors, such as market demand, the state of the economy, technology, competition, and unforeseen threats or opportunities. These factors cannot be reliably quantified. Therefore, investors must understand this limitation when making decisions.

Payback Analysis

Investment criteria are the defined set of parameters used by financial and strategic buyers to assess an acquisition target. The two most used investment criterion methods by firms are the internal rate of return (IRR) and net present value (NPV).

The payback period is a key component of payback analysis. It refers to the amount of time it takes to recover the cost of an investment or, in other words, the length of time an investment takes to reach a breakeven point. The payback period is calculated by dividing the amount of the investment by the annual cash flow. A shorter payback period is generally more desirable, indicating a more attractive investment.

• Understand the payback period formula: Payback period = initial investment / annual payback. The initial investment refers to the amount of money put into the project, while the annual payback is the amount of money made each year from the investment.
• Collect project data: Gather information on the available projects, the estimated investment amount, and the projected annual payback.
• Calculate the payback period: Use the payback period formula to determine the estimated returns for each project.
• Compare projects: Evaluate the payback periods for each project, considering additional factors such as resource availability and installation. The project with the lowest payback period may be the preferred choice as it can be paid off faster.

Throughput Analysis

Throughput is the quantity of a service or product that a company can produce and deliver to a client within a specified period. It is calculated using the following formula:

> Throughput = Inventory / Time Spent in Production

The goal of measuring throughput is to identify and minimise the weakest links in the production process, thereby maximising revenues. Companies with high throughput can outcompete their peers by producing goods or services more efficiently.

To increase throughput, companies can use real-time monitoring and data analysis, implement standardised checklists, or introduce competition among workers using scorecards.

• Throughput: sales minus totally variable expenses, which is usually sales minus the cost of direct materials and commissions.
• Operating expenses: all expenses, excluding totally variable expenses. These are the costs required to maintain the production system.
• Investment: the amount of cash invested to increase the capacity of the production system to produce more units.

These concepts can be applied to various financial analysis scenarios using the following formulas:

• Revenue – totally variable expenses = throughput
• Throughput – operating expenses = net profit
• Net profit / investment = return on investment

When considering alterations to the production system, companies should ask the following questions:

• Is there an incremental increase in throughput?
• Is there an incremental reduction in operating expenses?
• Is there an incremental increase in the return on investment?

The best improvements are those that increase throughput, as there is theoretically no upper limit on throughput.

In summary, throughput analysis is a valuable tool for companies to optimise their production processes, increase efficiency, and maximise revenues.

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